1) Behavioral Finance
360&deg;Behavioral View
September 2015
Our Periodic Review Exploring Multiple Topics Related to Behavioral Finance
&bull; Market Driven &bull; Economic &bull; Psychological &bull; Probabilistic &bull; Investable &bull;
Perception is Everything!
Frame Dependence and its Impact on Human Decision Making
&ldquo;The whole of science is nothing more than a refinement of everyday thinking.&rdquo;
-- Albert Einstein
Perception often trumps reality. It has been said that the best financial advisors are the ones
who can most successfully manage to their clients&rsquo; sense of perception rather than to reality.
The key to this is developing an understanding as to how people take in news, events, and
market conditions and in turn predict how that information will be interpreted. In other
words, how will my client &ldquo;frame&rdquo; or view current events, and, based on that framing, how
will he or she react next?
Frame dependence is a cognitive bias in which people show a tendency to react to a certain
choice in varying ways all depending on how the choice is presented or framed. For example,
research has shown that individuals will avoid risk when something is presented in a positive
or profitable light, and conversely, they will tend to seek risk when something is presented or
framed in a negative or unprofitable manner. Framing is about form and style and it reflects a
blend of the cognition of our minds as well as a range of our prevailing emotions at the time of
a decision.
The dictionary defines perception as &ldquo;to become aware of through the senses,&rdquo; and also as &ldquo;an
immediate or intuitive recognition or appreciation, as of moral, psychological, or aesthetic
qualities.&rdquo; So much of what we decide to do or how we feel in any given situation is largely
impacted by how we perceive the circumstances. At times, the impact of our perceptions (and
the framing that results from our perceptions) can be huge. Advertising executives are keenly
aware of this principle. The goal of any successful marketing campaign is to take a product or
service and present it in a slightly different light in order to change the public&rsquo;s perception
about it. The Coca-Cola Company figured this out over 100 years ago. A carbonated and
sweetened beverage widely offered at a reasonable price is not too much of a remarkable thing
on its own physical merits. What Coke figured out from its earliest days is that its product
needed to be consistently pictured alongside and associated with all activities and settings the
public defined as good, fun and desirable (gatherings, sporting events, days at the beach, etc.).
Coke&rsquo;s marketing has always equated fun and enjoyment in life with their product. What is
the result of this strategy that launched in the year 1886? In 2014, Coca-Cola provided over 693
billion individual servings of its products worldwide.
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2) Behavioral Finance
360&deg;Behavioral View
September 2015
Marketers are also aware that due to the framing that goes on in the mind of a consumer that a
sweater on display at full price for $50 will not sell as many units as the identical sweater on
display for $50 marked down from $75. For better or for worse, shoppers routinely perceive
that a product that is marked down on sale is inherently a better value proposition than a
product that is not marked down. Numerous other examples exist related to how successful
marketing campaigns shift our perceptions which in turn alter our decision making. However
advertising is not the sole domain as perception shifting is alive and well in government,
public policy and charitable endeavors. In the last five years, municipal governments around
the globe have learned that a simple low cost measure can greatly enhance the riding
experience of daily commuters on subways and trains. They have installed countdown clocks
on platforms to indicate exactly when the next train will arrive. Knowing your train will arrive
in 7 minutes is a much preferable experience to not knowing if your train is arriving in 4
minutes or 15 minutes, particularly if you are frantically running late. Removing a big chunk
of anxiety for most riders by creating an element of certainty enhances the experience for all.
Thus the train operators have been successful in re-framing a negative experience (waiting
anxiously on the platform) to at least a neutral or positive experience.
In Spain, after medical shortages of organs and tissues, the government shifted the policy for
those seeking a driver&rsquo;s license or government ID card. For decades the policy had been that
people seeking a new card had to choose to opt-in for organ donation. The government
changed the policy so that the default option indicated organ donation. If a person feels
strongly about not having their organs donated they must take an active role to check the optout box on their application form. As a result of this shift and re-framing, the shortages have
ceased.
What about in the world of investing? The manner in which people perceive investment
opportunities and the manner in which many people trade is largely a function of our
psychology and how our brain perceives and frames. People hate to lose things. We hate it
when our favorite sports team loses. We hate to lose arguments. We hate to lose our place in
line. And we really hate it when we lose money. Sometimes when we lose things, we work
hard (sometimes too hard) to either make it up or to prevent it from happening again. In
particular as it relates to losing money there is a tendency in the majority of people to take on
unwarranted risk for the sake of reversing the situation. Behavioral economist Hersh Shefrin
coined the term &ldquo;get-even-itis&rdquo; to describe the tendency many people have in taking on
excessive levels of risk all for the goal of getting back to a position of break-even after
sustaining losses.
An extreme example of get-even-itus can be observed in the case of Nicholas Leeson. Leeson
worked for Barings, PLC and through a series of events he became a rogue trader. His intense
desire to &ldquo;get back to break even&rdquo; single handedly caused the failure of the 232 year old
financial institution. In the span of 1992-1995 he began to engage in rogue trades in order to
hide trade errors made by himself and his subordinates. The strategy initially worked.
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3) Behavioral Finance
360&deg;Behavioral View
September 2015
Eventually, the sum total of the losses of the trades made to cover up other trades
compounded. Leeson took on more risk and engaged in more rogue trades. In the end he lost
over $1.4 billion of his employer&rsquo;s capital.
Things are not what they really are. Rather, they are what we think they are. Ultimately, we
are all prisoners of how our minds perceive and frame investment situations. At Sterling, we
recognize the difficulty involved with separating the biases that enter into the appraisal of a
situation or portfolio opportunity at the moment of perceiving it from what it might actually
be in reality. As a result all of our behaviorally driven portfolios are designed to intentionally
remove the portfolio managers personal bias or opinion from the decision making process. We
seek to intentionally remove the bias that can be inherent in our own framing and instead rely
on the strength of our behavioral stock ranking investment process.
FOR INSTITUTIONAL USE ONLY. NOT TO BE DISTRIBUTED OR COMMUNICATED TO THE GENERAL PUBLIC
The opinions contained in the preceding commentary reflect those of Sterling Capital Management LLC, and not those of BB&amp;T
Corporation or its executives. The stated opinions are for general information only and are not meant to be predictions or an offer of
individual or personalized investment advice. This information and these opinions are subject to change without notice. Any type of
investing involves risk and there are no guarantees. Sterling Capital Management LLC does not assume liability for any loss which may
result from the reliance by any person upon such information or opinions.
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